Abhi Final Asbm

8/8/2019 Abhi Final Asbm

1/78

ASIAN SCHOOL OF BUSINESS MANAGEMEMT

A PROJECT REPORT ON

DERIVATIVE MARKET IN INDIA

CORPORATE GUIDE-MR.BIJAN PANDA

SUBMITTED FOR PARTIAL FULFILLMENT FOR AWARD OF THE DEGREE

OF

POSTGRADUATE PROGRAM IN INTERNATIONAL BUSINESS(REG.N0-PGPIB 01-09/11)

SUBMITTED TO SUBMITTED BYSHAREKHAN PVT.LTD ABHISHEK

JOSHI BHUBANESWAR

PGPIB,ASBM ABHISHEK JOSHI


2/78

BHUBANESWAR

PGPIB, ASBM

DECLARATION

This is the report of the project work entitled DERIVATIVE MARKET IINDIA

undertaken by me during the two month training at share khan, Bhubaneswar

I hereby declare that project report is being submitted by me to the Departmentof PGPIB for the partial fulfilment of the degree of POSTGRADUATEPROGRAM INTERNATIONAL BUSINESS.

A copy of this project has been submitted to the organization where the projectwas developed. This project is not submitted to any other organization oruniversity or College and is the Outcome of my work.


3/78

Date- signature

ASBM,PGPIB


4/78

A C K N O W L E D G E M E N T TO COMPANY

I wish to extend my sincere gratitude to, Mr. Bijan panda,Ast.Branch

Manager, sharekhan Securities Ltd., for providing me with all the facilities to

carry on this research work efficiently.

I also extend my gratitude towards Mr. Prashanta kumar Nanda for helping

me in the completion of this report, the entire team at sharekhan, for their co-

operation and last but not the least the employees at sharekhan for theirsupport and encouragement in fulfilment of this report.

Date- Signature


5/78

Acknowledgement to the FacultyASIAN SCHOOL OF BUSINESS Management

It is high privilege for me to express my deep sense of gratitude to all

Those faculty members who helped me in the completion of the

project, especially my ASBM Director DR. BISWAJEET PATNAIK who

was always. There at hour of need.

My special thanks to DR.NITIKANT CHAND (FACULTY OF BUSINESS

COMUNICATION) for helping me in the completion of project work andits report submission.

Last but not the least my special thanks to the faculty ofAsian school

of business management

For their kind cooperation and providing me with all the necessary

documents needed and guidance during the time period of project

completion.

DR.NITIRANJAN CHAND

ASBM,BHUBANESWAR


6/78

TO WHOMSOEVER IT MAY CONCERN

On behalf SHAREKHAN Ltd., I take the privilege of recognizing the efforts put

in by Mr. ABHISHEK JOSHI to carry out her Project on Indian Derivative

Market from 19th APRIL to 12th JuNE 2010. ABHISHEK has not onlycarried out this study as a part of his curriculum but he has proven to be a keymember in bringing positive contribution in our Sales strategies.

The project carried out by ABHISHEK has given us some focused reasons to

improve our people practices, focus on employee satisfaction level as well

contribute to our sales. In fact we are considering adapting a few suggestions

given by him in the above context.

Lastly, I would like to thank your esteemed institution for providing your

students such a platform; for them to learn from their experiences while

carrying out these studies.

Warm regards,

(BIJAN PANDA)AST.branch

Manager


7/78

CONTENTS1. Executive Summary ......2. Company Profile...................3. Introduction ...................4.5.

6.7.8.

Need of the Study............................................................................Literatures

Review............................................................................Objective of the Study.....................................................................Scope of the Study..........................................................................

10. Main Topics of Study1) Introduction to Derivative.............................................................2) Derivative Defined.........................................................................3) Types of Derivatives Market...........................................................4) Types of Derivatives......................................................................

i) Forward Contracts......................................................................ii) Future Contracts........................................................................iii)iv)

Options.......................................................................................Swap.......................................................................................

5) Other Kinds of Derivatives.........................................................11. History of Derivatives.........................................................................12. Indian Derivative Market ..........

1)2)

i)

ii)

3)4)5)

Need of Derivatives in India today................................Myths and realities about derivatives..................

Derivatives increase speculation and do not serve anyeconomic purpose .....................................................................Indian Market is not ready for derivative trading.........................

Comparison of New System with Existing System.........Exchange-traded vs. OTC derivatives markets...............................Factors Contributing To The Growth Of Derivatives........................

i) Price Volatility..............................................................................ii)iii)

Globalisation of Markets..............................................................Technological Advances..............................................................

iv) Advances in Financial Theories........................................13. Development of Derivative Markets in India.......14.

1)2)

3)4)

Benifits of Derivatives...................................Risk Management............................................................................Price Discovery..............................................................................

Operational Advantages.................................................................Market Efficiency............................................................................


8/78

5) Easy to Speculation.........................................................................15. National Exchanges.........................................................................16.17.

1819.20.21.22

Present Status.................................................................................Status Report of the development in Derivative Market.................

questionerBusiness Growth in Derivatives segment (NSE).............................Findings & Conclusion.....................................................................Recommendations & Suggestions..................................................Bibliography ........

23. Abbrevations...................................................................................


9/78

EXECUTIVE SUMMARYFirstly I am briefing the current Indian market and comparing it with it past. I

am also giving brief data about foreign market. Then at the last I am giving my

suggestions and recommendations.

With over 25 million shareholders, India has the third largest investor base in

the world after USA and Japan. Over 7500 companies are listed on the Indian

stock exchanges (more than the number of companies listed in developed

markets of Japan, UK, Germany, France, Australia, Switzerland, Canada and

Hong Kong.). The Indian capital market is significant in terms of the degree of

development, volume of trading, transparency and its tremendous growth

potential.Indias market capitalization was the highest among the emerging markets.

Total market capitalization of The Bombay Stock Exchange (BSE), which, as

on July 31, 1997, was US$ 175 billion has grown by 37.5% percent every

twelve months and was over US$ 834 billion as of January, 2007. Bombay

Stock Exchanges (BSE), one of the oldest in the world, accounts for the

largest number of listed companies transacting their shares on a nationwide

online trading system. The two major exchanges namely the National Stock

Exchange (NSE) and the Bombay Stock Exchange (BSE) ranked no. 3 & 5 in

the world, calculated by the number of daily transactions done on the

exchanges.

The Total Turnover of Indian Financial Markets crossed US$ 2256 billion in

2006 An increase of 82% from US $ 1237 billion in 2004 in a short span of 2

years only. Turnover in the Spot and Derivatives segment both in NSE & BSE

was higher by 45% into 2006 as compared to 2005. With daily average

volume of US $ 9.4 billion, the Sensex has posted excellent returns in the


10/78

recent years. Currently the market cap of the Sensex as on July 4th, 2009

was Rs 48.4 Lakh Crore with a P/E of more than 20.

Derivatives trading in the stock market have been a subject of enthusiasm of

research in the field of finance the most desired instruments that allow market

participants to manage risk in the modern securities trading are known as

derivatives. The derivatives are defined as the future contracts whose value

depends upon the underlying assets. If derivatives are introduced in the stock

market, the underlying asset may be anything as component of stock market

like, stock prices or market indices, interest rates, etc. The main logic behind

derivatives trading is that derivatives reduce the risk by providing an

additional channel to invest with lower trading cost and it facilitates the

investors to extend their settlement through the future contracts. It provides

extra liquidity in the stock market.

Derivatives are assets, which derive their values from an underlying asset.

These underlying assets are of various categories like

Commodities including grains, coffee beans, etc.

Precious metals like gold and silver.

Foreign exchange rate.

Bonds of different types, including medium to long-term negotiable debt

securities issued by governments, companies, etc.

Short-term debt securities such as T-bills.

Over-The-Counter (OTC) money market products such as loans or deposits.

Equities

For example, a dollar forward is a derivative contract, which gives the buyer aright & an obligation to buy dollars at some future date. The prices of the

derivatives are driven by the spot prices of these underlying assets.

However, the most important use of derivatives is in transferring market risk,

called Hedging, which is a protection against losses resulting from unforeseen

price or volatility changes. Thus, derivatives are a very important tool of risk

management.


11/78

There are various derivative products traded. They are;

1. Forwards

2. Futures

3. Options

4. Swaps

A Forward Contractis a transaction in which the buyer and the seller agree

upon a delivery of a specific quality and quantity of asset usually a commodity

at a specified future date. The price may be agreed on in advance or in

future.

A Future contract is a firm contractual agreement between a buyer and

seller for a specified as on a fixed date in future. The contract price will vary

according to the market place but it is fixed when the trade is made. The

contract also has a standard specification so both parties know exactly what

is being done.

An Options contract confers the right but not the obligation to buy (call

option) or sell (put option) a specified underlying instrument or asset at a

specified price the Strike or Exercised price up until or an specified future

date the Expiry date. The Price is called Premium and is paid by buyer of

the option to the seller or writer of the option.

A call option gives the holder the right to buy an underlying asset by a

certain date for a certain price. The seller is under an obligation to fulfill the

contract and is paid a price of this, which is called "the call option premium orcall option price".

A put option, on the other hand gives the holder the right to sell an

underlying asset by a certain date for a certain price. The buyer is under an

obligation to fulfil the contract and is paid a price for this, which is called "the

put option premium or put option price".

Swaps are transactions which obligates the two parties to the contract to

exchange a series of cash flows at specified intervals known as payment or


12/78

settlement dates. They can be regarded as portfolios of forward's contracts. A

contract whereby two parties agree to exchange (swap) payments, based on

some notional principle amount is called as a SWAP. In case of swap, only

the payment flows are exchanged and not the principle amount

I had conducted this research to find out the perception of investor

towards derivative market or its beneficial or not? You will be glad to

know that derivative market in India is the most booming now days.

So the person who is ready to take risk and want to gain more should

invest in the derivative market.

On the other hand RBI has to play an important role in derivative

market. Also SEBI must encourage investment in derivative market so

that the investors get the benefit out of it. Sorry to say that today even

educated persons are not willing to invest in derivative market because

they have the fear of high risk.

So, SEBI should take necessary steps for improvement in Derivative

Market so that more investors can invest in Derivative market.


13/78

ABOUT SHAREKHAN COMPANY INTRODUCTION

SSKI (Shripal Sevantilal Kantilal Ishwarlal ) investors Services Pvt. Ltd. offers

World- Sharekhan is stock broking company. ShareKhan comes under retail arm of

class facilities for buying and selling Shares on BSE and NSE, DemateServices(DP)Derivatives(F&O). SSKI group also comprises of Institutional broking

and Corporate Finance. Sharekhan does not claim expertise in too many things.

Sharekhan's expertise lies in stocks and that's what he talks about with authority. So

when he says that investing in stocks should not be confused with trading in stocks or

a portfolio-based strategy is better than betting on a single horse, it is something that

is spoken with years of focused learning and experience in the stock markets. And

these beliefs are reflected in everything Sharekhan does for you!

Those of you who feel comfortable dealing with a human being and would rather visit

a brick-and-mortar outlet than talk to a PC, you'd be glad to know that Sharekhan

offers you the facility to visit (or talk to) any of our share shops across the country. In

fact Sharekhan runs India's largest chain of share shops with over hundred outlets in

more than 80 cities! What's a share shop? How do you locate a share shop in your

city?

Sharekhan is 80 years old company which is started online in the year 2000 & it is the

first company who started online in 1984 they ventured into institutional broking&

corporate finance. They having 14 branches, 400 franchises also having 466 shops in

210 cities.


14/78

CURRENT POSITION

VISION

To empower the investor with quality advice and superior service to help him take

better investment decisions. We believe that our growth depends on client

satisfaction.

MISSION

To provide the best customer service and product innovation tuned to diverse

needs of clientele

Continuous up-gradation with changing technology, while maintaining human

values.

Respond to progressive globalization and achieving international standard.

Efficiency and effectiveness built on ethical practices.

CORE VALUE

Customer satisfaction through

Providing quality service effectively and efficiently

Smile, it enhances your face value is a service quality stressed on

periodic customer service Audits

Maximization of stakeholder value

Success through Teamwork, integrity and People


15/78

About Sharekhan

SSKI named its online division as SHARE KHAN and it is into retail Broking

The business of the company overhauled 4 years ago on February 8, 2000.

It acts as a discount brokerage house to a full service investment solutions

provider

It has a 150 member strong team.

It has specialized research product for the small investors and day traders

.it has 240 branch and 800 franchise all over india.

It has $25m/trades every day.

Leading player today with 20% market share

Over 1000000 online clients

The site was also launched on February 8, 2000 and named it as

www.sharekhan.com

The SpeedTrade account of share khan is the next generation technology

product launched on April 17, 2002

SpeedTradePlus was launched on October 28, 2002 for trading in Derivatives

It offers its customers with the trade execution facilities on the NSE, for cash

as well as derivatives, depository services


16/78

1. Sharekhan provides 4 in 1 account.

2. Demat a/c

3. Trading a/c: for cash calculation4. Bank a/c: for fund transfer

5. Mutual fund schemes

6. Dial and Trade: for query relating trading Products:

7. Bonds

8. Shares -online and offline

9. Portfolio Management System Insurance Commodities

Demat account: Sharekhan is a depository participant. This means that we can

keep the shares in dematerialized form in Sharekhan. But for this one has to the

demat account in Sharekhan. Dematerialization is the process by which a client can

get physical certificates converted into electronic balances maintained in his account

with the DP. In Sharekhan, under demat account there are two types of terminals.

Share Khan Classic accountAllow investor to buy and sell stocks online along with the following featureslike multiple watch lists, Integrated Banking, demat and digital contracts, Real-time portfolio tracking with price alerts and Instant credit & transfer.

ShareKhan Speed Trade account

This accounts for active traders who trade frequently during the day'strading session. Following are few popular features of Speed Tradeaccount

Single screen interface for cash and derivatives

Real-time streaming quotes with Instant order Execution &

Confirmation

Hot keys similar to a traditional broker terminal

Alerts and reminders

Back-up facility to place trades on Direct Phone lines


17/78

MY SIP IN SHAREKHAN

Before my Summer Internship Programmed, I had very little knowledge about the

stock market and its fundamentals. And now after undergoing training for the 8th

week at Sharekhan there is a tremendous increase in my knowledge about the stock

market. I have also gained a lot of knowledge about the Sharekhan Company and its

various products, schemes and policies and also about its competitors. The products

which I have sold up till now are Demat accounts and mutual funds. And I am

confident about my knowledge about demat accounts and mutual funds. Although

nobody can claim complete expertise but there is a sea change at least from my point

of view. I have learnt what are the various Indices and their significance in market. I

have also learnt the impact of Sensex and Nifty on overall stock market.I have learnt

about various fundamentals and technical aspects, which affect the stock prices in

short, run and long run.t Sharekhan we have also been taught to use the online

terminal. Sharekhan is one of the top retail brokerage houses in India with a strong

online trading platform. The company provides equity based products (research,

equities, derivatives, depository, margin funding, etc.). It has one of the largest

networks in the country with 1000 share shops in 375 cities and Indias premier

online trading portal www.sharekhan.com. Out of these we have to mostly sell demat

accounts and Mutual Funds.

In the first week we had training sessions for 3 days in which our company guide Mr.

bijan panda gave us the complete information about the company, its products and

policies. He gave us tips on how to open and close the calls. He also gave us tips on

how to do telecalling. He also gave us information on how to fill the KYC form and

what are the documents required to open the demat account. Then finally after this

we were sent to the market to bring demat accounts and Mutual funds. Initially we

faced many obstacles and reasons were many like bad stock market

conditions And we were unable to locate potential market etc.but slowly I collected

a good number of leads and references from hom so ever I met. I am still following

the clients who are giving follow up dates During this venture I came across many

people who came from different walks of life. I have learned How to deal with them

and convince them to open the demat account with Sharekhan. Selling a demat


18/78

account requires special focus on targeting the customer Each and every person does

not invest in the share market. The person who will be investing in the share market

should have at least the basic knowledge about the same or should have the curiosity

to gain the same. So what I had to do is to identify the prospective client and then try

to convince them. Wasting time on the customer who does not know Anything about

stock market is completely worthless. While on the call if customer asks me any

query about which I am not very much sure then I call our prasnta sir my interal

corporate guide who then clears my doubts and queries without any irritation. This

not only solves clients query but also makes our concepts clear and strong. I initially

met 2 to people every day. Out of these I found 5 to 6 persons who took actual

interest in the Demat account and Mutual funds. As I met more and more people, I

learned how to identify the prospective clients. I came to know more about how to

talk to them, how much time should be given to each client. So my clients

conversion ratio also increased. Even, by solving the customer queries, my own

understandings were enhanced. While selling our product in the market, I also came

to know more about our competitor's product like, ICICIDirect, India bulls, India

Infoline, Broking etc. and their strategy of marketing and the consumer's preference

towards the competitor's product. I did cold calling in these three months and created

my own database through it. In the second month some of the follow-ups from the

first month started converting. Sharekhan also started giving advertisement in leading

English dailies and on channels like CNBC where the customers care toll free number

is displayed. Sharekhan also started giving ads on the various sites like Yahoo,

Google etc.Sharekhan also started a scheme of free demat account opening and also

the one in which the brokerage reduces to half of the original brokerage of 0.05% for

Intraday and 0.05% for Delivery.I met people in different locations i.e. at saheednagar,acharya bihar,nayapalli,.. This includes people from the Big Showrooms and

malls like Big Bazzar, Chartered Accountants, Travel agents, business people,

housewives, real estate people, Customer Relationship Managers, Assistant Sales

Manager, and engineers of some companies. and give the report to my company

guide.


19/78

INTRODUCTIONA Derivative is a financial instrument whose value depends on other, more

basic, underlying variables. The variables underlying could be prices of

traded securities and stock, prices of gold or copper.

Derivatives have become increasingly important in the field of finance,

Options and Futures are traded actively on many exchanges, Forward

contracts, Swap and different types of options are regularly traded outside

exchanges by financial intuitions, banks and their corporate clients in what

are termed as over-the-counter markets in other words, there is no

single market place or organized exchanges.

NEED OF THE STUDYThe study has been done to know the different types of derivatives and also to

know the derivative market in India and perception of investor towards Indian

derivative market . This study also covers the recent developments in the

derivative market taking into account the trading in past years.

Through this study I came to know the trading done in derivatives and their use in

the stock markets.


20/78

LITERATURE REVIEWThe emergence of the market for derivative products, most notably forwards, futures

and options, can be traced back to the willingness of risk-averse economic agents to

guard themselves against uncertainties arising out of fluctuations in asset prices. By

their very nature, the financial markets are marked by a very high degree of volatility.

Through the use of derivative products, it is possible to partially or fully transfer price

risks by locking-in asset prices. As instruments of risk management, these generally

do not influence the fluctuations in the underlying asset prices. However, by locking-

in asset prices, derivative products minimize the impact of fluctuations in asset prices

on the profitability and cash flow situation of risk-averse investors.

Derivative products initially emerged, as hedging devices against fluctuations in

commodity prices and commodity-linked derivatives remained the sole form of such

products for almost three hundred years. The financial derivatives came into spotlight

in post-1970 period due to growing instability in the financial markets. However,

since their emergence, these products have become very popular and by 1990s, they

accounted for about two-thirds of total transactions in derivative products. In recent

years, the market for financial derivatives has grown tremendously both in terms of

variety of instruments available, their complexity and also turnover. In the class of

equity derivatives, futures and options on stock indices have gained more popularity

than on individual stocks, especially among institutional investors, who are major

users of index-linked derivatives.

Even small investors find these useful due to high correlation of the popular indices

with various portfolios and ease of use. The lower costs associated with index

derivatives vis-vis derivative products based on individual securities is another reasonfor their growing use.

As in the present scenario, Derivative Trading is fast gaining momentum, I

have chosen this topic.


21/78

OBJECTIVES OF THE STUDY

To understand the concept of the Derivatives and Derivative Trading.

To know different types of Financial Derivatives

To know the role of derivatives trading in India.

To analyse the performance of Derivatives Trading since 2001with special

reference to Futures & Options

To know the perception of investor towards derivative market

SCOPE OF THE PROJECT

The project covers the derivatives market and its instruments. For better

understanding various strategies with different situations and actions have been

given. It includes the data collected in the recent years and also the market in the

derivatives in the recent years. This study extends to the trading of derivatives

done in the National Stock Markets.


22/78

MAIN TOPICS OF STUDY

INTRODUCTION TO DERIVATIVE

The origin of derivatives can be traced back to the need of farmers to protect

themselves against fluctuations in the price of their crop. From the time it was sown

to the time it was ready for harvest, farmers would face price uncertainty. Through

the use of simple derivative products, it was possible for the farmer to partially or

fully transfer price risks by locking-in asset prices. These were simple contracts

developed to meet the needs of farmers and were basically a means of reducing risk.

A farmer who sowed his crop in June faced uncertainty over the price he

would receive for his harvest in September. In years of scarcity, he would probably

obtain attractive prices. However, during times of oversupply, he would have to

dispose off his harvest at a very low price. Clearly this meant that the farmer and his

family were exposed to a high risk of price uncertainty.

On the other hand, a merchant with an ongoing requirement of grains too

would face a price risk that of having to pay exorbitant prices during dearth, althoughfavourable prices could be obtained during periods of oversupply. Under such

circumstances, it clearly made sense for the farmer and the merchant to come together

and enter into contract whereby the price of the grain to be delivered in September

could be decided earlier. What they would then negotiate happened to be futures-type

contract, which would enable both parties to eliminate the price risk.

In 1848, the Chicago Board Of Trade, or CBOT, was established to bring

farmers and merchants together. A group of traders got together and created the to-

arrive contract that permitted farmers to lock into price upfront and deliver the grain

later. These to-arrive contracts proved useful as a device for hedging and speculation

on price charges. These were eventually standardized, and in 1925 the first futures

clearing house came into existence.


23/78

Today derivatives contracts exist on variety of commodities such as corn,

pepper, cotton, wheat, silver etc. Besides commodities, derivatives contracts also

exist on a lot of financial underlying like stocks, interest rate, exchange rate, etc.

DERIVATIVE DEFINED

A derivative is a product whose value is derived from the value of one or more

underlying variables or assets in a contractual manner. The underlying asset can be

equity, forex, commodity or any other asset. In our earlier discussion, we saw that

wheat farmers may wish to sell their harvest at a future date to eliminate the risk of

change in price by that date. Such a transaction is an example of a derivative. The

price of this derivative is driven by the spot price of wheat which is the underlying

in this case.

The Forwards Contracts (Regulation) Act, 1952, regulates the forward/futures

contracts in commodities all over India. As per this the Forward Markets Commission

(FMC) continues to have jurisdiction over commodity futures contracts. However

when derivatives trading in securities was introduced in 2001, the term security in

the Securities Contracts (Regulation) Act, 1956 (SCRA), was amended to include

derivative contracts in securities. Consequently, regulation of derivatives came underthe purview of Securities Exchange Board of India (SEBI). We thus have separate

regulatory authorities for securities and commodity derivative markets.

Derivatives are securities under the SCRA and hence the trading of derivatives is

governed by the regulatory framework under the SCRA. The Securities Contracts

(Regulation) Act, 1956 defines derivative to include-

A security derived from a debt instrument, share, loan whether secured or unsecured,

risk instrument or contract differences or any other form of security.

A contract which derives its value from the prices, or index of prices, of underlying

securities.


24/78

Derivatives

Future Option Forward Swaps

TYPES OF DERIVATIVES MARKET

Exchange Traded Derivatives Over The Counter Derivatives

National Stock Bombay Stock NationalCommodity &

Exchange Exchange DerivativeExchange

Index Future Index option Stock option Stock future

Figure.1 Types of Derivatives Market

TYPES OF DERIVATIVES


25/78

Figure.2 Types of Derivatives

Over The Counter Exchange of India (OTCEI)

Traditionally, trading in Stock Exchanges in India followed a conventional stylewhere people used to gather at the Exchange and bids and offers were made by open

outcry.

This age-old trading mechanism in the Indian stock markets used to create many

functional inefficiencies. Lack of liquidity and transparency, long settlement periods

and benami transactions are a few examples that adversely affected investors. In order

to overcome these inefficiencies, OTCEI was incorporated in 1990 under the

Companies Act 1956. OTCEI is the first screen based nationwide stock exchange in

India created by Unit Trust of India, Industrial Credit and Investment Corporation of

India, Industrial Development Bank of India, SBI Capital Markets, Industrial FinanceCorporation of India, General Insurance Corporation and its subsidiaries and Can

Bank Financial Services.

Exchange traded derivative

Exchange-traded derivative contracts are standardized derivative contracts (e.g.

futures contracts and options) that are transacted on an organized futures exchange.

These contracts can includefutures, callandput. Part of the name of these contracts

always reflects on which date the contract expire. For example, a future ABC

expiring in September 2006 will be called ABC U06. A call (C) option ABC expiring

in September 2006 will be called ABC I06C. A put (P) option ABC expiring in

September 2006 will be called ABC U06P.

Months Call Put Futures

Jan. A M F

Feb. B N G

Mar C O HApr. D P J

May E Q K

Jun. F R M

Jul. G S N

Aug. H T Q

Sept. I U U

Oct. J V V

Nov. K W X

Dec. L X Z
http://en.wikipedia.org/wiki/Call_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Put_optionhttp://en.wikipedia.org/wiki/Call_option


26/78

Over the counter derevative

A type offinancialderivative that has its transaction directly negotiated between twoparties rather than through an exchange. Some financial derivatives, such as aswap, a

forward rate agreement or an exotic option, are usually doneover the counter.

(i) FORWARD CONTRACTS

A forward contract is an agreement to buy or sell an asset on a specified date for

a specified price. One of the parties to the contract assumes a long position and

agrees to buy the underlying asset on a certain specified future date for a

certain specified price. The other party assumes a short position and agrees to

sell the asset on the same date for the same price. Other contract details like

delivery date, price and quantity are negotiated bilaterally by the parties to the

contract. The forward contracts are n o r m a l l y traded outside the exchanges.

BASIC FEATURES OF FORWARD CONTRACT

They are bilateral contracts and hence exposed to counter-party risk.

Each contract is custom designed, and hence is unique in terms of contract

size, expiration date and the asset type and quality.

The contract price is generally not available in public domain.

On the expiration date, the contract has to be settled by delivery of the

asset.

If the party wishes to reverse the contract, it has to compulsorily go to the

same counter-party, which often results in high prices being charged.

However forward contracts in certain markets have become very

standardized, as in the case of foreign exchange, thereby reducing

transaction costs and increasing transactions volume. This process of

standardization reaches its limit in the organized futures market. Forward

contracts are often confused with futures contracts. The confusion is primarily

bec aus e bo th serve essentially the same economic fun ct io ns of allocating

risk in the presence of future price uncertainty. However futures are a significant
http://www.investorwords.com/5572/financial.htmlhttp://www.investorwords.com/1421/derivative.htmlhttp://www.investorwords.com/5046/transaction.htmlhttp://www.investorwords.com/3610/party.htmlhttp://www.investorwords.com/1797/exchange.htmlhttp://www.investorwords.com/1797/exchange.htmlhttp://www.investorwords.com/4838/swap.htmlhttp://www.investorwords.com/4838/swap.htmlhttp://www.investorwords.com/2070/Forward_Rate_Agreement.htmlhttp://www.investorwords.com/6805/exotic_option.htmlhttp://www.investorwords.com/3557/Over_the_Counter.htmlhttp://www.investorwords.com/3557/Over_the_Counter.htmlhttp://www.investorwords.com/5572/financial.htmlhttp://www.investorwords.com/1421/derivative.htmlhttp://www.investorwords.com/5046/transaction.htmlhttp://www.investorwords.com/3610/party.htmlhttp://www.investorwords.com/1797/exchange.htmlhttp://www.investorwords.com/4838/swap.htmlhttp://www.investorwords.com/2070/Forward_Rate_Agreement.htmlhttp://www.investorwords.com/6805/exotic_option.htmlhttp://www.investorwords.com/3557/Over_the_Counter.html


27/78

improvement over the forward contracts as they eliminate counterparty risk

and offer more liquidity.

(ii) FUTURE CONTRACT

In finance, a futures contract is a standardized contract, traded on a futures exchange,

to buy or sell a certain underlying instrument at a certain date in the future, at a pre-

set price. The future date is called the delivery date or final settlement date. The pre-

set price is called the futures price. The price of the underlying asset on the delivery

date is called the settlement price. The settlement price, normally, converges towards

the futures price on the delivery date.

A futures contract gives the holder the right and the obligation to buy or sell, which

differs from an options contract, which gives the buyer the right, but not the

obligation, and the option writer (seller) the obligation, but not the right. To exit the

commitment, the holder of a futures position has to sell his long position or buy back

his short position, effectively closing out the futures position and its contract

obligations. Futures contracts are exchange traded derivatives. The exchange acts as

counterparty on all contracts, sets margin requirements, etc.

BASIC FEATURES OF FUTURE CONTRACT

1. Standardization :Futures contracts ensure their liquidity by being highly standardized, usually by

specifying:

The underlying. This can be anything from a barrel of sweet crude oil to a

short term interest rate.

The type of settlement, either cash settlement or physical settlement.

The amount and units of the underlying asset per contract. This can be the

notional amount of bonds, a fixed number of barrels of oil, units of foreign


28/78

currency, the notional amount of the deposit over which the short term interest

rate is traded, etc.

The currency in which the futures contract is quoted.

Thegrade of the deliverable. In case of bonds, this specifies which bonds canbe delivered. In case of physical commodities, this specifies not only the

quality of the underlying goods but also the manner and location of delivery.

The delivery month.

The last trading date.

Other details such as the tick, the minimum permissible price fluctuation.

2. Margin :Although the value of a contract at time of trading should be zero, its price constantly

fluctuates. This renders the owner liable to adverse changes in value, and creates a

credit risk to the exchange, who always acts as counterparty. To minimize this risk,

the exchange demands that contract owners post a form of collateral, commonly

known as Margin requirements are waived or reduced in some cases for hedgers who

have physical ownership of the covered commodity or spread traders who have

offsetting contracts balancing the position.

Initial Margin: is paid by both buyer and seller. It represents the loss on that

contract, as determined by historical price changes, which is not likely to be exceeded

on a usual day's trading. It may be 5% or 10% of total contract price.

Mark to market Margin:Because a series of adverse price changes may exhaust

the initial margin, a further margin, usually called variation or maintenance margin, is

required by the exchange. This is calculated by the futures contract, i.e. agreeing on a

price at the end of each day, called the "settlement" or mark-to-market price of the

contract.

To understand the original practice, consider that a futures trader, when taking a

position, deposits money with the exchange, called a "margin". This is intended to

protect the exchange against loss. At the end of every trading day, the contract is

marked to its present market value. If the trader is on the winning side of a deal, his

contract has increased in value that day, and the exchange pays this profit into his

account. On the other hand, if he is on the losing side, the exchange will debit his

account. If he cannot pay, then the margin is used as the collateral from which the

loss is paid.


29/78

3. SettlementSettlement is the act of consummating the contract, and can be done in one of two

ways, as specified per type of futures contract:

Physical delivery - the amount specified of the underlying asset of thecontract is delivered by the seller of the contract to the exchange, and by the

exchange to the buyers of the contract. In practice, it occurs only on a minority of

contracts. Most are cancelled out by purchasing a covering position - that is,

buying a contract to cancel out an earlier sale (covering a short), or selling a

contract to liquidate an earlier purchase (covering a long).

Cash settlement -a cash payment is made based on the underlying reference

rate, such as a short term interest rate index such as Euribor, or the closing value

of a stock market index. A futures contract might also opt to settle against an

index based on trade in a related spot market.

Expiry is the time when the final prices of the future are determined. For many

equity index and interest rate futures contracts, this happens on the Last Thursday of

certain trading month. On this day the t+2 futures contract becomes the t forward

contract.

PRICING OF FUTURE CONTRACTIn a futures contract, for no arbitrage to be possible, the price paid on delivery (the

forward price) must be the same as the cost (including interest) of buying and storing

the asset. In other words, the rational forward price represents the expected future

value of the underlying discounted at the risk free rate. Thus, for a simple, non-

dividend paying asset, the value of the future/forward, , will be found by

discounting the present value at time to maturity by the rate of risk-free

return .

This relationship may be modified for storage costs, dividends, dividend yields, and

convenience yields. Any deviation from this equality allows for arbitrage as follows.

In the case where the forward price is higher:

1. The arbitrageur sells the futures contract and buys the underlying today (on

the spot market) with borrowed money.

2. On the delivery date, the arbitrageur hands over the underlying, and receives

the agreed forward price.


30/78

3. He then repays the lender the borrowed amount plus interest.

4. The difference between the two amounts is the arbitrage profit.

In the case where the forward price is lower:

1. The arbitrageur buys the futures contract and sells the underlying today (on

the spot market); he invests the proceeds.

2. On the delivery date, he cashes in the matured investment, which has

appreciated at the risk free rate.

3. He then receives the underlying and pays the agreed forward price using the

matured investment. [If he was short the underlying, he returns it now.]

4. The difference between the two amounts is the arbitrage profit.

OPTIONS -

A derivative transaction that gives the option holder the right but not the obligation to

buy or sell the underlying asset at a price, called the strike price, during a period or on

a specific date in exchange for payment of a premium is known as option.

Underlying asset refers to any asset that is traded. The price at which the underlying

is traded is called the strike price.

There are two types of options i.e., CALL OPTION & PUT OPTION.

CALL OPTION:

A contract that gives its owner the right but not the obligation to buy an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is

known as a Call option. The owner makes a profit provided he sells at a higher

current price and buys at a lower future price.

PUT OPTION:

A contract that gives its owner the right but not the obligation to sell an underlying

asset-stock or any financial asset, at a specified price on or before a specified date is

known as a Put option. The owner makes a profit provided he buys at a lower


31/78

current price and sells at a higher future price. Hence, no option will be exercised if

the future price does not increase.

Put and calls are almost always written on equities, although occasionally preference

shares, bonds and warrants become the subject of options.

SWAPS -

Swaps are transactions which obligates the two parties to the contract to exchange a

series of cash flows at specified intervals known as payment or settlement dates. They

can be regarded as portfolios of forward's contracts. A contract whereby two parties

agree to exchange (swap) payments, based on some notional principle amount is

called as a SWAP. In case of swap, only the payment flows are exchanged and not

the principle amount. The two commonly used swaps are:

INTEREST RATE SWAPS:

Interest rate swaps is an arrangement by which one party agrees to exchange his

series of fixed rate interest payments to a party in exchange for his variable rate

interest payments. The fixed rate payer takes a short position in the forward contract

whereas the floating rate payer takes a long position in the forward contract.

CURRENCY SWAPS:

Currency swaps is an arrangement in which both the principle amount and the interest

on loan in one currency are swapped for the principle and the interest payments on

loan in another currency. The parties to the swap contract of currency generally hail

from two different countries. This arrangement allows the counter parties to borrow

easily and cheaply in their home currencies. Under a currency swap, cash flows to be

exchanged are determined at the spot rate at a time when swap is done. Such cash

flows are supposed to remain unaffected by subsequent changes in the exchange

rates.

FINANCIAL SWAP:

Financial swaps constitute a funding technique which permit a borrower to access one

market and then exchange the liability for another type of liability. It also allows the

investors to exchange one type of asset for another type of asset with a preferred

income stream.


32/78

OTHER KINDS OF DERIVATIVESThe other kind of derivatives, which are not, much popular are as

follows:

BASKETS -

Baskets options are option on portfolio of underlying asset. Equity Index Options are

most popular form of baskets.

LEAPS -

Normally option contracts are for a period of 1 to 12 months. However,

exchange may introduce option contracts with a maturity period of 2-3 years. These

long-term option contracts are popularly known as Leaps or Long term Equity

Anticipation Securities.

WARRANTS -

Options generally have lives of up to one year, the majority of options traded

on options exchanges having a maximum maturity of nine months. Longer-

dated options are called warrants and are generally traded over-the-counter.

SWAPTIONS -

Swaptions are options to buy or sell a swap that will become operative at the expiry

of the options. Thus a swaption is an option on a forward swap. Rather than have calls

and puts, the swaptions market has receiver swaptions and payer swaptions. A

receiver swaption is an option to receive fixed and pay floating. A payer swaption isan option to pay fixed and receive floating.


33/78

HISTORY OF DERIVATIVES:

The history of derivatives is quite colourful and surprisingly a lot longer than most

people think. Forward delivery contracts, stating what is to be delivered for a fixed

price at a specified place on a specified date, existed in ancient Greece and Rome.

Roman emperors entered forward contracts to provide the masses with their supply of

Egyptian grain. These contracts were also undertaken between farmers and merchants

to eliminate risk arising out of uncertain future prices of grains. Thus, forward

contracts have existed for centuries for hedging price risk.

The first organized commodity exchange came into existence in

the early 1700s in Japan. The first formal commodities exchange, the Chicago Board

of Trade (CBOT), was formed in 1848 in the US to deal with the problem of credit

risk and to provide centralised location to negotiate forward contracts. From

forward trading in commodities emerged the commodity futures. The first type of

futures contract was called to arrive at. Trading in futures began on the CBOT in the

1860s. In 1865, CBOT listed the first exchange traded derivatives contract, known

as the futures contracts. Futures trading grew out of the need for hedging the price

risk involved in many commercial operations. The Chicago Mercantile Exchange(CME), a spin-off of CBOT, was formed in 1919, though it did exist before in 1874

under the names of Chicago Produce Exchange (CPE) and Chicago Egg and Butter

Board (CEBB). The first financial futures to emerge were the currency in 1972 in the

US. The first foreign currency futures were traded on May 16, 1972, on International

Monetary Market (IMM), a division of CME. The currency futures traded on the

IMM are the British Pound, the Canadian Dollar, the Japanese Yen, the Swiss Franc,

the German Mark, the Australian Dollar, and the Euro dollar. Currency futures were

followed soon by interest rate futures. Interest rate futures contracts were traded for

the first time on the CBOT on October 20, 1975. Stock index futures and options

emerged in 1982. The first stock index futures contracts were traded on Kansas City

Board of Trade on February 24, 1982.The first of the several networks, which offered

a trading link between two exchanges, was formed between the Singapore

International Monetary Exchange (SIMEX) and the CME on September 7, 1984.


34/78

Options are as old as futures. Their history also dates back to ancient Greece and

Rome. Options are very popular with speculators in the tulip craze of seventeenth

century Holland. Tulips, the brightly coloured flowers, were a symbol of affluence;

owing to a high demand, tulip bulb prices shot up. Dutch growers and dealers traded

in tulip bulb options. There was so much speculation that people even mortgaged

their homes and businesses. These speculators were wiped out when the tulip craze

collapsed in 1637 as there was no mechanism to guarantee the performance of the

option terms.

The first call and put options were invented by an American

financier, Russell Sage, in 1872. These options were traded over the counter.

Agricultural commodities options were traded in the nineteenth century in England

and the US. Options on shares were available in the US on the over the counter

(OTC) market only until 1973 without much knowledge of valuation. A group of

firms known as Put and Call brokers and Dealers Association was set up in early

1900s to provide a mechanism for bringing buyers and sellers together.

On April 26, 1973, the Chicago Board options Exchange (CBOE)

was set up at CBOT for the purpose of trading stock options. It was in 1973 again that

black, Merton, and Scholes invented the famous Black-Scholes Option Formula. This

model helped in assessing the fair price of an option which led to an increased interest

in trading of options. With the options markets becoming increasingly popular, the

American Stock Exchange (AMEX) and the Philadelphia Stock Exchange (PHLX)

began trading in options in 1975.

The market for futures and options grew at a rapid pace in the eighties and nineties.

The collapse of the Bretton Woods regime of fixed parties and the introduction of

floating rates for currencies in the international financial markets paved the way for

development of a number of financial derivatives which served as effective risk

management tools to cope with market uncertainties.

The CBOT and the CME are two largest financial exchanges in the world on which

futures contracts are traded. The CBOT now offers 48 futures and option contracts

(with the annual volume at more than 211 million in 2001).The CBOE is the largest

exchange for trading stock options. The CBOE trades options on the S&P 100 and the


35/78

S&P 500 stock indices. The Philadelphia Stock Exchange is the premier exchange for

trading foreign options.

The most traded stock indices include S&P 500, the Dow Jones Industrial

Average, the Nasdaq 100, and the Nikkei 225. The US indices and the Nikkei 225

trade almost round the clock. The N225 is also traded on the Chicago Mercantile

Exchange.

INDIAN DERIVATIVES MARKET

Starting from a controlled economy, India has moved towards a world where prices

fluctuate every day. The introduction of risk management instruments in India gained

momentum in the last few years due to liberalisation process and Reserve Bank of

Indias (RBI) efforts in creating currency forward market. Derivatives are an integral

part of liberalisation process to manage risk. NSE gauging the market requirements

initiated the process of setting up derivative markets in India. In July 1999,

derivatives trading commenced in India

Table 2. Chronology of instruments

1991 Liberalisation process initiated

14 December 1995 NSE asked SEBI for permission to trade index futures.

18 November 1996 SEBI setup L.C.Gupta Committee to draft a policy framework

for index futures.

11 May 1998 L.C.Gupta Committee submitted report.

7 July 1999 RBI gave permission for OTC forward rate agreements

(FRAs) and interest rate swaps.

24 May 2000 SIMEX chose Nifty for trading futures and options on an

Indian index.

25 May 2000 SEBI gave permission to NSE and BSE to do index futures

trading.9 June 2000 Trading of BSE Sensex futures commenced at BSE.

12 June 2000 Trading of Nifty futures commenced at NSE.

25 September 2000 Nifty futures trading commenced at SGX.

2 June 2001 Individual Stock Options & Derivatives

(1) Need for derivatives in India today

In less than three decades of their coming into vogue, derivatives markets have

become the most important markets in the world. Today, derivatives have become

part and parcel of the day-to-day life for ordinary people in major part of the world.


36/78

Until the advent of NSE, the Indian capital market had no access to the latest trading

methods and was using traditional out-dated methods of trading. There was a huge

gap between the investors aspirations of the markets and the available means of

trading. The opening of Indian economy has precipitated the process of integration of

Indias financial markets with the international financial markets. Introduction of risk

management instruments in India has gained momentum in last few years thanks to

Reserve Bank of Indias efforts in allowing forward contracts, cross currency options

etc. which have developed into a very large market.

(ii) Indian Market is not ready for derivative trading

Often the argument put forth against derivatives trading is that the Indian capital

market is not ready for derivatives trading. Here, we look into the pre-requisites,

which are needed for the introduction of derivatives, and how Indian market fares:

TABLE 3.

PRE-REQUISITES INDIAN SCENARIO

Large marketCapitalisation

India is one of the largest market-capitalised countriesin Asia with a market capitalisation of more thanRs.765000 crores.

High Liquidity in the

underlying

The daily average traded volume in Indian capital

market today is around 7500 crores. Which means onan average every month 14% of the countrys Marketcapitalisation gets traded. These are clear indicators ofhigh liquidity in the underlying.

Trade guarantee The first clearing corporation guaranteeing trades hasbecome fully functional from July 1996 in the form of National Securities Clearing Corporation (NSCCL). NSCCL is responsible for guaranteeing all openpositions on the National Stock Exchange (NSE) forwhich it does the clearing.

A Strong Depository National Securities Depositories Limited (NSDL)which started functioning in the year 1997 hasrevolutionalised the security settlement in our country.

A Good legal guardian In the Institution of SEBI (Securities and ExchangeBoard of India) today the Indian capital market enjoysa strong, independent, and innovative legal guardianwho is helping the market to evolve to a healthier

place for trade practices.


37/78

FACTORS CONTRIBUTING TO THE GROWTH OF DERIVATIVES:

Factors contributing to the explosive growth of derivatives are price volatility,

globalisation of the markets, technological developments and advances in the

financial theories.

A.} PRICE VOLATILITY

A price is what one pays to acquire or use something of value. The objects having

value maybe commodities, local currency or foreign currencies. The concept of price

is clear to almost everybody when we discuss commodities. There is a price to be

paid for the purchase of food grain, oil, petrol, metal, etc. the price one pays for use of

a unit of another persons money is called interest rate. And the price one pays in

ones own currency for a unit of another currency is called as an exchange rate.

Prices are generally determined by market forces. In a market, consumers have

demand and producers or suppliers have supply, and the collective interaction of

demand and supply in the market determines the price. These factors are constantly

interacting in the market causing changes in the price over a short period of time.

Such changes in the price are known as price volatility. This has three factors: the

speed of price changes, the frequency of price changes and the magnitude of price

changes.

The changes in demand and supply influencing factors culminate in market

adjustments through price changes. These price changes expose individuals,

producing firms and governments to significant risks. The break down of the

BRETTON WOODS agreement brought and end to the stabilising role of fixed

exchange rates and the gold convertibility of the dollars. The globalisation of the

markets and rapid industrialisation of many underdeveloped countries brought a new

scale and dimension to the markets. Nations that were poor suddenly became a major

source of supply of goods. The Mexican crisis in the south east-Asian currency crisis

of 1990s has also brought the price volatility factor on the surface. The advent of

telecommunication and data processing bought information very quickly to the

markets. Information which would have taken months to impact the market earlier

can now be obtained in matter of moments.


38/78

Even equity holders are exposed to price risk of corporate share fluctuates rapidly.

These price volatility risks pushed the use of derivatives like futures and options

increasingly as these instruments can be used as hedge to protect against adverse price

changes in commodity, foreign exchange, equity shares and bonds.

B.} GLOBALISATION OF MARKETS

Earlier, managers had to deal with domestic economic concerns; what happened in

other part of the world was mostly irrelevant. Now globalisation has increased the

size of markets and as greatly enhanced competition .it has benefited consumers who

cannot obtain better quality goods at a lower cost. It has also exposed the modern

business to significant risks and, in many cases, led to cut profit margins

In Indian context, south East Asian currencies crisis of 1997 had affected the

competitiveness of our products vis--vis depreciated currencies. Export of certain

goods from India declined because of this crisis. Steel industry in 1998 suffered its

worst set back due to cheap import of steel from south East Asian countries. Suddenly

blue chip companies had turned in to red. The fear of china devaluing its currency

created instability in Indian exports. Thus, it is evident that globalisation of industrial

and financial activities necessitates use of derivatives to guard against future losses.

This factor alone has contributed to the growth of derivatives to a significant extent.

C.} TECHNOLOGICAL ADVANCES

A significant growth of derivative instruments has been driven by technological

breakthrough. Advances in this area include the development of high speed

processors, network systems and enhanced method of data entry. Closely related to

advances in computer technology are advances in telecommunications. Improvement

in communications allow for instantaneous worldwide conferencing, Data

transmission by satellite. At the same time there were significant advances in

software programmes without which computer and telecommunication advances

would be meaningless. These facilitated the more rapid movement of information and

consequently its instantaneous impact on market price.

Although price sensitivity to market forces is beneficial to the economy as a whole

resources are rapidly relocated to more productive use and better rationed overtime


39/78

the greater price volatility exposes producers and consumers to greater price risk. The

effect of this risk can easily destroy a business which is otherwise well managed.

Derivatives can help a firm manage the price risk inherent in a market economy. To

the extent the technological developments increase volatility, derivatives and risk

management products become that much more important.

D.} ADVANCES IN FINANCIAL THEORIES

Advances in financial theories gave birth to derivatives. Initially forward contracts in

its traditional form, was the only hedging tool available. Option pricing models

developed by Black and Scholes in 1973 were used to determine prices of call and put

options. In late 1970s, work of Lewis Edeington extended the early work of Johnson

and started the hedging of financial price risks with financial futures. The work of

economic theorists gave rise to new products for risk management which led to the

growth of derivatives in financial markets.

The above factors in combination of lot many factors led to growth of derivatives

instruments

DEVELOPMENT OF DERIVATIVES MARKET IN INDIA

The first step towards introduction of derivatives trading in India was the

promulgation of the Securities Laws (Amendment) Ordinance, 1995, which withdrew

the prohibition on options in securities. The market for derivatives, however, did not

take off, as there was no regulatory framework to govern trading of derivatives. SEBI

set up a 24member committee under the Chairmanship of Dr.L.C.Gupta on

November 18, 1996 to develop appropriate regulatory framework for derivatives

trading in India. The committee submitted its report on March 17, 1998 prescribing

necessary preconditions for introduction of derivatives trading in India. The

committee recommended that derivatives should be declared as securities so that

regulatory framework applicable to trading of securities could also govern trading

of securities. SEBI also set up a group in June 1998 under the Chairmanship of

Prof.J.R.Varma, to recommend measures for risk containment in derivatives market

in India. The report, which was submitted in October 1998, worked out the

operational details of margining system, methodology for charging initial margins,


40/78

broker net worth, deposit requirement and realtime monitoring requirements. The

Securities Contract Regulation Act (SCRA) was amended in December 1999 to

include derivatives within the ambit of securities and the regulatory framework

were developed for governing derivatives trading. The act also made it clear that

derivatives shall be legal and valid only if such contracts are traded on a recognized

stock exchange, thus precluding OTC derivatives. The government also rescinded in

March 2000, the three decade old notification, which prohibited forward trading in

securities. Derivatives trading commenced in India in June 2000 after SEBI granted

the final approval to this effect in May 2001. SEBI permitted the derivative segments

of two stock exchanges, NSE and BSE, and their clearing house/corporation to

commence trading and settlement in approved derivatives contracts. To begin with,

SEBI approved trading in index futures contracts based on S&P CNX Nifty and

BSE30 (Sense) index. This was followed by approval for trading in options based on

these two indexes and options on individual securities.

The trading in BSE Sensex options commenced on June 4, 2001 and the trading in

options on individual securities commenced in July 2001. Futures contracts on

individual stocks were launched in November 2001. The derivatives trading on NSE

commenced with S&P CNX Nifty Index futures on June 12, 2000. The trading in

index options commenced on June 4, 2001 and trading in options on individual

securities commenced on July 2, 2001. Single stock futures were launched on

November 9, 2001. The index futures and options contract on NSE are based on S&P

CNX Trading and settlement in derivative contracts is done in accordance with the

rules, byelaws, and regulations of the respective exchanges and their clearing

house/corporation duly approved by SEBI and notified in the official gazette. Foreign

Institutional Investors (FIIs) are permitted to trade in all Exchange traded derivative

products.

The following are some observations based on the trading statistics provided in the

NSE report on the futures and options (F&O):

Single-stock futures continue to account for a sizable proportion of the F&O

segment. It constituted 70 per cent of the total turnover during June 2002. A primary


41/78

reason attributed to this phenomenon is that traders are comfortable with single-stock

futures than equity options, as the former closely resembles the erstwhile badla

system.

On relative terms, volumes in the index options segment continue to remain

poor. This may be due to the low volatility of the spot index. Typically, options are

considered more valuable when the volatility of the underlying (in this case, the

index) is high. A related issue is that brokers do not earn high commissions by

recommending index options to their clients, because low volatility leads to higher

waiting time for round-trips.

Put volumes in the index options and equity options segment have increased

since January 2002. The call-put volumes in index options have decreased from 2.86

in January 2002 to 1.32 in June. The fall in call-put volumes ratio suggests that the

traders are increasingly becoming pessimistic on the market.

Farther month futures contracts are still not actively traded. Trading in equity

options on most stocks for even the next month was non-existent.

Daily option price variations suggest that traders use the F&O segment as a

less risky alternative (read substitute) to generate profits from the stock price

movements. The fact that the option premiums tail intra-day stock prices is evidence

to this. If calls and puts are not looked as just substitutes for spot trading, the intra-

day stock price variations should not have a one-to-one impact on the option

premiums.

The spot foreign exchange market remains the most important segment

but the derivative segment has also grown. In the derivative market

foreign exchange swaps account for the largest share of the total

turnover of derivatives in India followed by forwards and options.

Significant milestones in the development of derivatives market have

been (i) permission to banks to undertake cross currency derivative

transactions subject to certain conditions (1996) (ii) allowing corporates to


42/78

undertake long term foreign currency swaps that contributed to the

development of the term currency swap market (1997) (iii) allowing

dollar rupee options (2003) and (iv) introduction of currency futures

(2008). I would like to emphasise that currency swaps allowed companies

with ECBs to swap their foreign currency liabilities into rupees.

However, since banks could not carry open positions the risk was allowed

to be transferred to any other resident corporate. Normally such risks

should be taken by corporates who have natural hedge or have potential

foreign exchange earnings. But often corporate assume these risks due to

interest rate differentials and views on currencies.

This period has also witnessed several relaxations in regulations relating to forex

markets and also greater liberalisation in capital account regulations leading to

greater integration with the global economy.

Cash settled exchange traded currency futures have made foreign currency

a separate asset class that can be traded without any underlying need or

exposure a n d on a leveraged basis on the recognized stock exchanges

with credit risks being assumed by the central counterparty

Since the commencement of trading of currency futures in all the three exchanges,

the value of the trades has gone up steadily from Rs 17, 429 crores in October

2008 to Rs 45, 803 crores in December 2008. The average daily turnover in all

the exchanges has also increased from Rs871 crores to Rs 2,181 crores during the

same period. The turnover in the currency futures market is in line with the

international scenario, where I understand the share of futures market ranges

between 2 3 per cent.

Table 4.1ForexMarketActivity

April05-

Mar06

April06-

Mar07

April07-

Mar08

April08-

Dec08Total turnover (USD billion) 4,404 6,571 12,304 9,621

Inter-bank to Merchant ratio 2.6:1 2.7:1 2.37: 1 2.66:1


43/78

Spot/Total Turnover (%) 50.5 51.9 49.7 45.9

Forward/Total Turnover (%) 19.0 17.9 19.3 21.5

Swap/Total Turnover (%) 30.5 30.1 31.1 32.7

Source: RBI

BENEFITS OF DERIVATIVES

Derivative markets help investors in many different ways:

1.] RISK MANAGEMENT

Futures and options contract can be used for altering the risk of investing in spot

market. For instance, consider an investor who owns an asset. He will always be

worried that the price may fall before he can sell the asset. He can protect himself by

selling a futures contract, or by buying a Put option. If the spot price falls, the short

hedgers will gain in the futures market, as you will see later. This will help offset

their losses in the spot market. Similarly, if the spot price falls below the exercise

price, the put option can always be exercised.

2.] PRICE DISCOVERY Price discovery refers to the markets ability to determine true equilibrium prices.

Futures prices are believed to contain information about future spot prices and help in

disseminating such information. As we have seen, futures markets provide a low cost

trading mechanism. Thus information pertaining to supply and demand easily

percolates into such markets. Accurate prices are essential for ensuring the correct

allocation of resources in a free market economy. Options markets provide

information about the volatility or risk of the underlying asset.

3.] OPERATIONAL ADVANTAGES

As opposed to spot markets, derivatives markets involve lower transaction costs.

Secondly, they offer greater liquidity. Large spot transactions can often lead to

significant price changes. However, futures markets tend to be more liquid than spot

markets, because herein you can take large positions by depositing relatively small

margins. Consequently, a large position in derivatives markets is relatively easier to

take and has less of a price impact as opposed to a transaction of the same magnitude


44/78

in the spot market. Finally, it is easier to take a short position in derivatives markets

than it is to sell short in spot markets.

4.] MARKET EFFICIENCY

The availability of derivatives makes markets more efficient; spot, futures and options

markets are inextricably linked. Since it is easier and cheaper to trade in derivatives, it

is possible to exploit arbitrage opportunities quickly and to keep prices in alignment.

Hence these markets help to ensure that prices reflect true values.

5.] EASE OF SPECULATION

Derivative markets provide speculators with a cheaper alternative to engaging in spot

transactions. Also, the amount of capital required to take a comparable position is less

in this case. This is important because facilitation of speculation is critical for

ensuring free and fair markets. Speculators always take calculated risks. A speculator

will accept a level of risk only if he is convinced that the associated expected return is

commensurate with the risk that he is taking.

The derivative market performs a number of economic functions.

The prices of derivatives converge with the prices of the underlying at the

expiration of derivative contract. Thus derivatives help in discovery of future

as well as current prices.

An important incidental benefit that flows from derivatives trading is that it

acts as a catalyst for new entrepreneurial activity.

Derivatives markets help increase savings and investment in the long run.

Transfer of risk enables market participants to expand their volume of activity.

15. National Exchanges

In enhancing the institutional capabilities for futures trading the idea of

setting up of National Commodity Exchange(s) has been pursued since 1999. Three

such Exchanges, viz, National Multi-Commodity Exchange of India Ltd., (NMCE),

Ahmedabad, National Commodity & Derivatives Exchange (NCDEX), Mumbai,


45/78

and Multi Commodity Exchange (MCX), Mumbai have become operational.

National Status implies that these exchanges would be automatically

permitted to conduct futures trading in all commodities subject to clearance

of byelaws and contract specifications by the FMC. While the NMCE, Ahmedabad

commenced futures trading in November 2002, MCX and NCDEX, Mumbai

commenced operations in October/ December 2003 respectively.

MCX

MCX (Multi Commodity Exchange of India Ltd.) an independent and de-

mutulised multi commodity exchange has permanent recognition from Government

of India for facilitating online trading, clearing and settlement operations forcommodity futures markets across the country. Key shareholders of MCX are

Financial Technologies (India) Ltd., State Bank of India, HDFC Bank, State Bank of

Indore, State Bank of Hyderabad, State Bank of Saurashtra, SBI Life Insurance Co.

Ltd., Union Bank of India, Bank of India, Bank of Baroda,

Canera Bank, Corporation Bank

Headquartered in Mumbai, MCX is led by an expert management team with

deep domain knowledge of the commodity futures markets. Today MCX is offering

spectacular growth opportunities and advantages to a large cross section of the

participants including Producers / Processors, Traders, Corporate, Regional Trading

Canters, Importers, Exporters, Cooperatives, Industry Associations, amongst others

MCX being nation-wide commodity exchange, offering multiple commodities for

trading with wide reach and penetration and robust infrastructure.

MCX, having a permanent recognition from the Government of India, is an

independent and demutualised multi commodity Exchange. MCX, a state-of-the-art

nationwide, digital Exchange, facilitates online trading, clearing and settlement

operations for a commodities futures trading.

NMCE

National Multi Commodity Exchange of India Ltd. (NMCE) was promoted by

Central Warehousing Corporation (CWC), National Agricultural CooperativeMarketing Federation of India (NAFED), Gujarat Agro-Industries Corporation


46/78

Limited (GAICL), Gujarat State Agricultural Marketing Board (GSAMB), National

Institute of Agricultural Marketing (NIAM), and Neptune Overseas Limited (NOL).

While various integral aspects of commodity economy, viz., warehousing,

cooperatives, private and public sector marketing of agricultural commodities,

research and training were adequately addressed in structuring the Exchange, finance

was still a vital missing link. Punjab National Bank (PNB) took equity of the

Exchange to establish that linkage. Even today, NMCE is the only Exchange in India

to have such investment and technical support from the commodity relevant

institutions.

NMCE facilitates electronic derivatives trading through robust and tested

trading platform, Derivative Trading Settlement System (DTSS), provided by

CMC. It has robust delivery mechanism making it the most suitable for the

participants in the physical commodity markets. It has also established fair and

transparent rule-based procedures and demonstrated total commitment towards

eliminating any conflicts of interest. It is the only Commodity Exchange in the world

to have received ISO 9001:2000 certification from British Standard Institutions (BSI).

NMCE was the first commodity exchange to provide trading facility through internet,

through Virtual Private Network (VPN).

NMCE follows best international risk management practices. The contracts

are marked to market on daily basis. The system of upfront margining based on Value

at Risk is followed to ensure financial security of the market. In the event of high

volatility in the prices, special intra-day clearing and settlement is held. NMCE was

the first to initiate process of dematerialization and electronic transfer of warehoused

commodity stocks. The unique strength of NMCE is its settlements via a Delivery

Backed System, an imperative in the commodity trading business. These deliveries

are executed through a sound and reliable Warehouse Receipt System, leading to

guaranteed clearing and settlement.


47/78

NCDEX

National Commodity and Derivatives Exchange Ltd (NCDEX) is a

technology driven commodity exchange. It is a public limited company

registered under the Companies Act, 1956 with the Registrar of Companies,

Maharashtra in Mumbai on April 23,2003. It has an independent Board of

Directors and professionals not having any vested interest in commodity

markets. It has been launched to provide a world-class commodity exchange

platform for market participants to trade in a wide spectrum of commodity

derivatives driven by best global practices, professionalism and transparency.

Forward Markets Commission regulates NCDEX in respect of futures tradingin commodities. Besides, NCDEX is subjected to various laws of the land like the

Companies Act, Stamp Act, Contracts Act, Forward Commission (Regulation) Act

and various other legislations, which impinge on its working. It is located in Mumbai

and offers facilities to its members in more than 390 centres throughout India. The

reach will gradually be expanded to more centres.

NCDEX currently facilitates trading of thirty six commodities - Cashew,Castor Seed, Chana, Chilli, Coffee, Cotton, Cotton Seed Oilcake, Crude Palm Oil,

Expeller Mustard Oil, Gold, Guar gum, Guar Seeds, Gur, Jeera, Jute sacking bags,

Mild Steel Ingot, Mulberry Green Cocoons, Pepper, Rapeseed - Mustard Seed ,Raw

Jute, RBD Palmolein, Refined Soy Oil, Rice, Rubber, Sesame Seeds, Silk, Silver,

Soy Bean, Sugar, Tur, Turmeric, Urad (Black Matpe), Wheat, Yellow Peas, Yellow

Red Maize & Yellow Soybean Meal.


48/78

TABLE4: THE CURRENT PROFILE OF FUTURES TRADING IN

INDIA WITH RESPECT TO THE VARIOUS EXCHANGES IN


49/78

INDIA:-


50/78

The Present Status:


51/78

Presently futures trading is permitted in all the commodities. Trading is

taking place in about 78 commodities through 25 Exchanges/Associations as given in

the table below:-

TABLE 4 Registered commodity exchanges in India

No. Exchange COMMODITY

1. India Pepper & Spice Trade

Association, Kochi (IPSTA)

Pepper (both domestic

and international

contracts)2. Vijai Beopar Chambers Ltd.,

Muzaffarnagar

Gur, Mustard seed

3. Rajdhani Oils & Oilseeds

Exchange Ltd., Delhi

Gur, Mustard seed its oil

& oilcake4. Bhatinda Om & Oil Exchange Ltd.,

Bhatinda

Gur

5. The Chamber of Commerce,

Hapur

Gur, Potatoes and

Mustard seed6. The Meerut Agro Commodities

Exchange Ltd., Meerut

Gur

7. The Bombay Commodity

Exchange Ltd., Mumbai

Oilseed Complex, Castor

oil international contracts8. Rajkot Seeds, Oil & Bullion

Merchants Association, Rajkot

Castor seed, Groundnut,

its oil & cake, cottonseed,

its oil & cake, cotton

(kapas) and RBD

palmolein.9. The Ahmedabad Commodity

Exchange, Ahmedabad

Castorseed, cottonseed,

its oil and oilcake

10. The East India Jute & Hessian

Exchange Ltd., Calcutta

Hessian & Sacking

11. The East India Cotton Association

Ltd., Mumbai

Cotton

12. The Spices & Oilseeds Exchange

Ltd., Sangli.

Turmeric

13. National Board of Trade, Indore Soya seed, Soyaoil and

Soya meals,

Rapeseed/Mustardseed

its oil and oilcake and


52/78

RBD Palmolien14. The First Commodities Exchange

of India Ltd., Kochi

Copra/coconut, its oil &

oilcake15. Central India Commercial

Exchange Ltd., Gwalior

Gur and Mustard seed

16. E-sugar India Ltd., Mumbai Sugar 17. National Multi-Commodity

Exchange of India Ltd.,

Ahmedabad

Several Commodities

18. Coffee Futures Exchange India

Ltd., Bangalore

Coffee

19. Surendranagar Cotton Oil &

Oilseeds, Surendranagar

Cotton, Cottonseed,

Kapas20. E-Commodities Ltd., New Delhi Sugar (trading yet to

commence)21. National Commodity &

Derivatives, Exchange Ltd.,

Mumbai

Several Commodities

22. Multi Commodity Exchange Ltd.,

Mumbai

Several Commodities

23. Bikaner commodity Exchange

Ltd., Bikaner

Mustard seeds its oil &

oilcake, Gram. Guar seed.Guar Gum

24. Haryana Commodities Ltd., Hissar Mustard seed complex25. Bullion Association Ltd., Jaipur Mustard seed Complex

Analysis of current derivative market of India

MARKET

1. The Board at its meeting on November 29, 2002 had desired that a quarterly

report be submitted to the Board on the developments in the derivative market.

Accordingly, this memorandum presents a status report for the quarter July-

September 2008-09 on the developments in the derivative market.

2. Equity Derivatives SegmentA. Observations on the quarterly data for July-September, 2008-09


53/78

During July-September 2008-09, the turnover at BSE was Rs.1,510 crore,

which was insignificant as compared to that of NSE at Rs. 3,315,491 crore.

Refer Table 1

Volume (no. of contracts) increased by 42.06% to 1,698.7 lakh while

turnover increased by 24.77% t

Documents

Abhi Final Asbm